Wage Growth Will Push Interest Rates Higher

Much is discussed about the potential for an inverted yield curve, a situation where short-term interest rates are higher than longer-term rates. The inverted yield curve has a good recent track record for predicting recessions as Chart 1 below shows. The red lines mark where the yield curve inverted – e.g. when short-term interest rates rose above long-term rates. There can, however, be quite a period of time between this yield curve inversion and the actual onset of recession (recessions are shown in the grayish sections on the chart).

Chart 1: Inverted yield curves precede recessions

One of the primary factors pushing the yield curve higher would be a hike in the rate of inflation. The largest driver, by far, of inflation is wage growth. Wages go up as labor supply tightens – e.g. as unemployment fails. Chart 2 details how wages rise as the unemployment rate declines. Unemployment goes from right to left on this chart, with labor supply getting tighter as you go left. You can see that as the dots go left, they rise, meaning that wages are rising as unemployment declines. We see that as unemployment comes down, the dots cluster around the 4-6% level of unemployment. It’s hard for unemployment to go below this number of 4%. As the dots cluster, they move higher, suggesting that wages begin growing as unemployment hits this natural bottom level. The orange dot is the most recent reading – it’s quite low in wage growth given the level of unemployment. The orange dot (today) is very near this natural bottom, leading us to conclude that wages might well start rising quickly.

Chart 2: As unemployment comes down, wages go up

The purple lines show the rise in wages (a full 2%) in the last economic cycle. So far in this cycle, we have not seen such an increase. That rise in wages would push inflation and interest rates higher. If it pushes interest rates higher out in time as well, then the yield curve does NOT invert and all is well. If wages rise, but bond investors do not believe that a strong economy is here to stay, the wages will push up short-term yields while longer-term yield do not rise as much – hence, the yield curve inverts. About 12-18 months later, a recession typically begins. A recession often brings with it a bearish stock market.

Here at TimingCube, we are poised to profit from a bearish stock market, just as we did in 2000-2002 and 2008. We are ready for the next bear market, whenever it comes. Right now, all is well, inflation is low, interest rates are low, the yield curve remains OK. A year from now, will that still be the case?

Market Update

Tech stocks continued their selloff Monday, their third straight day of weakness, with the Nasdaq dropping -1.4%. The selloff was precipitated by Facebook’s (FB) post-earnings -20% plunge the prior Thursday. Upbeat earnings from global economic bellweather Caterpillar (CAT) tried and failed to excite investors. The stock gave up a +3% rise early in the day to close down -2% over the course of the negative Monday trade. Investors were buoyed Tuesday by rumors of restarted trade talks between the U.S. and China. That idea bolstered industrial stocks while healthcare and consumer staples sectors also found buyers, driven by enthusiasm over Pfizer (PFE) and Proctor&Gamble (PG) earnings. A large build in oil inventories sent crude oil prices down Wednesday while strong earnings from Apple (AAPL) pushed the Nasdaq higher by +0.5%. The announcement of another possible round of tariffs on Chinese goods pressured industrial stocks, offsetting the good news from Apple in the broad market indexes. Concerns over the tariffs pushed stocks down early Thursday. But buyers came into the market throughout the day, reversing an opening loss to a +0.5% gain as Apple’s shares continued climbing in a post-earnings rally. The July employment report offered no surprises leaving investors clinging to a mostly positive mood Friday. Interest rates tumbled sending bank shares lower. This action kept small-cap indexes from participating in the Friday cheer. The S&P 500 added another +0.5% as the 2800 level continues to provide technical support for the index.

Stocks managed to overcome early weakness to close with another positive weekly showing. The S&P 500 (SPY) added +0.77% for its fifth consecutive week in the green. The Nasdaq 100 (QQQ) lifted +1.38% to revisit the 180 level that has proven to be stout resistance throughout July. Small-cap stocks (IWM) added +0.68% for the week.